“Diversification” is a word that gets thrown around a lot in the investment world. It’s a core principle in managing an investment portfolio to mitigate risk and achieve a higher overall blended return. Many people think it just refers to the stock market, but you should be thinking about it for your real estate investments as well. Effectively, a strong real estate portfolio diversification strategy can create both short-term revenue as well as long-term cash flow while providing a safety net for market volatility.
Understanding How to Compare Investment Risk and Returns
Different combinations of real estate investments produce different levels of risk and return. Essentially, as the returns increase, so does your risk. That’s why smart investors utilize a cornerstone idea of modern portfolio theory called efficient frontier. Simply put, efficient frontier is a model that represents the best real estate investment combinations, or those that produce the maximum expected return for a given level of risk. It focuses on the relationship between the investments rather than the potential performance of any single investment. The rationale is that some property holding types will perform well under certain market conditions while others will move in the opposite direction. Thus, an optimally distributed real estate investment portfolio can the lower the overall risk while maintaining returns.
The Efficient Frontier Model for Determining the Best Real Estate Investment Combinations
There is no single best portfolio location on the efficient frontier for every real estate investor because property holdings can be selected according to individual needs. For instance, one investor may require that each of their investments deliver a minimum return while another might be focused on impact investing to improve neighborhoods. The key is to understand your personal and financial goals as well as your overall tolerance for risk when developing your diversified real estate portfolio.
Categories of Diversification
When thinking about how to create a real estate portfolio that is in line with the efficient frontier, you need to strategize about ways to diversify your holdings. This can be done by spreading your property holdings across different categories. Specifically, you need to think about each property’s asset class, geographic location, holding period, and business model. Let’s take a look at what each of these categories means.
Asset Class. Generally speaking, real estate asset classes are property types that perform differently in certain market conditions. These can include single-family homes, condos, apartments, townhomes, and multi-family properties. Each real estate asset class can be further ranked according to its quality and typical risk/return ratio.
|Class A Properties||Class B Properties||Class C Properties|
|Class A properties are recently built and situated next to sought-after amenities that raise their value. These houses, apartments, and condos are the dream homes that only a select few have the privilege of living in. In New York, think about the Upper East Side, bordering Central Park, where many of the wealthy and socially prominent people live. Class A properties are usually owner occupied with only a handful being rented. These properties provide low returns on cash flow but are also fairly low risk. These properties may appreciate more, but if the market does drop, they will be the first to drop in value.||Class B properties are somewhat older homes that are occupied by middle-class professionals. You might find an odd unkempt yard, but overall the neighborhoods are clean, safe, and in proximity to decent schools and other amenities. Usually, about half of Class B properties are resident-owned with the other half being rented out by investors. In New York, many middle-class families and young professionals have been priced out of Manhattan to Class B properties in Brooklyn. These are the bread and butter of many real estate Investors because of the potential cash flow, growth potential, and range of exit strategies.||Class C properties can be found in older, often-blighted neighborhoods—like those found in Queens—and have been neglected or even abandoned. These homes need varying degrees of rehabilitation. As a result, investments in Class C properties are often higher-risk but can bring in higher returns, both monetarily and in terms of community-building. Investing in Class C properties and rehabbing them restores neighborhoods. These properties are also more likely to generate higher cash flow as rentals, but will likely not appreciate much, if at all, in value.|
The key to investing in any of these asset classes, of course, is to buy low and sell high. Whether you invest in a Class A or a Class C house, you will find the best returns on properties that need a little love and care to achieve full market potential.
There are many ways to think about geography for real estate investing, as it can be defined by neighborhoods, cities, states, or even trans-national boundaries. You’ve read news stories about high-dollar real estate investors who spread their portfolio over several different countries—but that’s not what you are dealing with. Rather, for a typical real estate investor, it makes sense to become an expert on a particular city or region, like New York or Chicago, and diversify assets within that market. In addition, evaluate the neighborhood itself. Is it a neighborhood on the way up, with new construction or renovation in the area? Or is it on the way down, with more renters and less pride of ownership?
Different holding periods come with varying degrees of risk and return. Short term holding periods can provide the best market certainty, but your exit strategy must unfold fairly quickly to achieve your targets. Mid-term holding periods can reduce the time-pressure, but the real estate market cycle may change, leaving you with somewhat less assurance. Some properties can generate stable, reliable cash flow when rented out over years. The biggest risk, of course, in holding a rental is loss of income due to vacancies, but multi-unit properties can help hedge against that financial exposure by providing multiple streams of income. Long holding periods can reduce risk but also bring the lowest annualized returns.
Diversifying the holding periods of individual properties can help sustain your portfolio despite market ups and downs. The basic idea is that you generally don’t want to exit all your properties at the same time in case the market happens to be against you at that particular moment. But, even when the market is on your side, exiting multiple properties at once can pose re-investment risks.
For each property in your portfolio, you will need to develop a business strategy for how it will contribute to the strength of your overall holdings. A property that you buy and hold as a rental for several years relies on a business model of building equity and carries the lowest risk. However, a property that you intend to rehab and sell immediately can provide the best annualized return on investment, though the risk is somewhat higher.
The good news is that your business strategy is not set in stone; you can change it according to current market conditions. Say, for instance, that you purchased and rehabbed a multi-family building in the Bronx as an equity builder with low cash flow but managing the rental became too cumbersome for your growing real estate investing business. You can simply put it on the market. Then, the model becomes one based on low equity build and moderate cash flow. Here are some examples of business models and their associated risks and returns.
|Business Models and Risk/Return|
|Equity Build With Low Cash Flow||Buy and Hold as Long-term Rental||Low Risk||Low Returns|
|Low Equity Build with Moderate Cash Flow||Buy and Hold as a Mid-term Rental||Moderate Risk||Moderate Returns|
|No Equity Build With High Cash Flow||Buy and Sell Wholesale||Moderate-High Risk||Moderate-High Returns|
|High Equity Build With High Cash Flow||Buy Distressed Property, Rehab, and Sell at Full Market Value||High Risk||High Returns|
Reaching the Efficient Frontier With a Diverse Portfolio
To build a real estate investment business with a strong portfolio, you are going to need a solid lead generation strategy to find properties across different asset classes in New York City neighborhoods. You can then realize varying returns based on your holding period and business model. Of course, the lowest risk investments will bring in the lowest returns, so you will need to diversify your portfolio with some higher risk investments, such as Class C properties to rehab and sell. This will bring your portfolio closer to the efficient frontier where risk and return are optimal.
If you have been disappointed in your real estate investment returns, it may be time to look at your business model. Perhaps you are not yet set up to appropriately mitigate the risks associated with higher-return investments to diversify your portfolio. But, with the right tools and resources at hand, acquiring and selling high cash flow properties doesn’t have to be intimidating.
In fact, HomeVestors® franchisees have been effectively building diverse real estate portfolios by investing in distressed properties of all types nationwide for over twenty years. HomeVestors® franchisees can leverage a tried-and-true business model, from training to marketing support, lead generation and a variety of exit strategies. With HomeVestors’ proprietary valuation tools and a designated mentor, a development agent, who has already achieved success in the New York City real estate market, you can make investments with more confidence, too. Are you ready to get more out of your investments? Get in touch today!
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